Another person who generally has the same effect, and like Jeremy was a true hero to clients who really listened over the last decade, is James Montier. First at Dresdner Kleinwort, and then Société Générale (with another gem, his colleague Albert Edwards) James expounded on value investing, behavioral finance and the perils of modern finance. Not that the bankers of Société Générale listened.

In a career move that makes perfect sense James has now joined Jeremy at GMO. With James and Ben Inker the GMO team will deserve respect long after Jeremy is gone.

Which gets me back to WoW!

James has produced an analysis of the crisis and its aftermath that is close to perfect. Not only are the ten points and his discussion enlightening in and of themselves, but the wisdom of other great investors is liberally sprinkled throughout. This is one of those pieces that says exactly what I think about a host of issues, but better. Here are a few highlights:

Lesson 1: Markets aren’t efficient.

One would think this would be obvious by now, but no, it isn’t to many.

Lesson 2: Relative performance is a dangerous game.

Personally I believe that it is to the benefit of those of us who refuse to play the relative performance game, but managers, consultants and the industry in general conspire against looking at things differently.

On the subject of the industries obsession with deciding how to categorize returns as alpha or beta or any number of ever finer benchmarks:

Sadly, these concepts are nothing more than a distraction from the true aim of investment, which as the late, great Sir John Templeton observed is, “Maximum total real returns after tax.”

Such a simplistic mind you have James worrying about what ends up in the bank account rather than beating a benchmark or proving your results are “alpha” rather than beta.

It is also nice to see James noticing studies which show managers can beat an index, they bizarrely choose not to. Go figure.

Lesson 3: The time is never different.

We better hope it is this time, because the history of collapsing credit bubbles certainly argues for several years of economic distress.

Lesson 4: Valuation matters.

Ultimately nothing has a greater impact on returns in the stock market than the price you pay. This is consistently denigrated but consistently proves true over time:

Oh, and in case you were wondering, we presently reside on the expensive end of that chart.

Lesson 5: Wait for the fat pitch.

The problem with this is that investors are impatient:

As tempting as it may be to be a “man of action,” it often makes more sense to act only at extremes. But the discipline required to “do nothing” for long periods of time is not often seen. As noted above, overt myopia also contributes to our inability to sit back, trying to understand the overall investment backdrop.

Waiting for the “fat pitch” as Warren Buffett calls it requires one to realize:

1. cash is a position
2. that it is okay not to do as well as everyone else while waiting for the right opportunity
3. the necessity of investing in opportunities not dependent on the stock markets direction
4. that you should respect dividends
5. you need to act when everyone else is in a state of panic
6. that it is only useful to panic if you do so before everyone else!

Warren Buffett often speaks of the importance of waiting for the fat pitch – that perfect moment when patience is rewarded as the ball meets the sweet spot. However, most investors seem unable to wait, forcing themselves into action at every available opportunity, swinging at every pitch, as it were.

Lesson 6: Sentiment matters.

The more enthusiastic investors are, the more cautious you should be, and vice versa.

Lesson 7: Leverage can’t make a bad investment good, but it can make a good investment bad!

In and of itself modest leverage can help a good investment, but only if you can live with the volatility long enough for the good investment to pay off. Excessive leverage destroys the ability to hold.

Lesson 8: Over-quantification hides real risk.

James quotes the great Ben Graham:

Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw there from … Whenever calculus is brought in, or higher algebra, you could take it as a warning that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.

This lesson especially appeals to me. As a long time fan of the “Its Bigger Than a Bread Box” school of investing I cannot agree more with the false sense of certainty and its dangers in applied investing. What I mean by “bigger than a bread box” goes back to lesson 6 and it paying most to act at extremes. Precision is not only unattainable then, but irrelevant. Look for something so important that getting it exactly right isn’t important. Everything else will likely amount to no more than short term noise.

I remember an investment committee meeting in early 2008 as the downturn we had been preparing for was in its early innings. The debate was going back and forth over how bad things might get. I decide it was time to cut to the chase:

Debating how bad things might get is like arguing after you have fallen off a building whether it is a 30 or 60 story fall. Either way you are dead. The real solution is the same either way, don’t fall off the damn building!

We moved on to how we should protect our capital and hopefully even profit from the coming collapse.

Here is another gem from James on how trying to mathematically calculate risk distracts us from what really matters:

In a depressing parody of the “build it and they will come” mentality, the risk management industry seems to believe “measure it, and it must be useful.” In investing, all too often risk is equated with volatility. This is nonsense. Risk isn’t volatility, it is the permanent loss of capital. Volatility creates opportunity. As Keynes noted, “It is largely fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”

We would be far better off if we abandoned our obsession with measurement in favor of understanding a trinity of risks. From an investment point of view, there are three main paths to the permanent loss of capital: valuation risk (buying an overvalued asset), business risk (fundamental problems), and financing risk (leverage). By understanding these three elements, we should get a much better understanding of the true nature of risk.

Interestingly, it is valuation risk which has proved hardest to avoid, and causes the most lasting damage to investors portfolios.

Lesson 9: Macro matters.

Big macro economic events can destroy what seems normal when it comes to valuation. The big risks need to be accounted for, even when they seem unlikely (bonus wisdom from the great Jean Marie Eveillard:

It often pays to remember the wise words of Jean-Marie Eveillard. “Sometimes, what matters is not so much how low the odds are that circumstances would turn quite negative, what matters more is what the consequences would be if that happens.” In terms of finance jargon, expected payoff has two components: expected return and probability. While the probability may be small, a truly appalling expected return can still result in a negative payoff.

[...]

Neither top-down nor bottom-up has a monopoly on insight. We should learn to integrate their dual perspectives.

Lesson 10: Look for sources of cheap insurance.

If low probability but disastrous events need to be accounted for, then finding ways to cheaply mitigate, or even profit from, them is important. Even if it is in the short term a drag on performance. Quality balance sheets in your stock holdings are cheap insurance right now, so are other strategies. We are closely looking at where cheap insurance can be found.

Read Ten Lessons Not learnt

Technorati Tags Ben Graham, GMO, James Montier, Jeremy Grantham, value investing

Yves Smith looks at the problem of how to handle the prospect of the financially weaker members of the European Union possibly defaulting. neither the PIIGS nor their colleague states want to take the steps they may need to take. Markets however are sending a clear message, “Do Something!” The risk goes beyond the direct damage from the potential losses from holding these countries debts. European banks are already shaky, with shaky assets and still a lot more leverage than is safe. I believe Europe’s bear market is likely back on.

European banks are shaky? How provincial of me not to mention our own banks. The coming wave of defaults in the Alt-A and Prime mortgage space are not getting enough attention, Yves helps out there as well. Not only are the losses coming (pretending loans are good only works until they actually default) but the banks are in for some serious lawsuits from all kinds of parties that bought the toxic loans. First in line are Freddie and Fannie. They will still lose at least 400 billion, but they’ll take a good chunk out of the banks hide on the way down.

the phrase “credit specialists at Citi” is not exactly the kind of thing which instills enormous confidence in analysts and investors these days

I think that is an understatement. They want to sell another fancy derivative designed to remove all risk if there is a systemic crisis when, of course, those supposed to pay up will certainly have the money to do so….Right?

Please imagine me banging my head against the keyboard. And no, the response of the Citi Spokesman doesn’t make me feel any different, in fact, it makes me feel worse.

The term liquidity is the pixie dust the financial commentariat uses to obscure what is really going on. I maintain, and have throughout the last few years, that our difficulties have not been a liquidity crisis (though many who had no business exposing themselves individually to liquidity drying up for them certain had a liquidity crisis) but a solvency crisis. David Merkel points out that liquidity always exists, it just goes where the marginal credit buyer  has gone. Where insolvency risk seems to be increasing, the marginal buyer can become very scarce and will provide it to areas seemingly exposed to less risk. At the end of the day it is solvency that is our problem, and until we solve that liquidity will go to those perceived to be least at risk. Right now that is the government and those they are backing.   Hence a credit crunch for much of the economy.

Speaking of credit, consumer credit has now declined for 11 straight months. A record, and by a long shot. (Click image for a larger version.)

In the “no big surprise department,” and paralleling the argument I made at the time, it has now been shown that the ban on short selling during the crisis did not help support prices and damaged stock market liquidity. In the no surprise at all department the biggest complainers turned out to have fundamental problems that short sellers were pointing out accurately (much better than our regulators.) The loudest complainer of all, Overstock.com and their bizarre CEO, Patrick Byrne. The upshot, they have been cooking their books for years, just like the short sellers were claiming.

Cross posted at The View from the Bluff

Technorati Tags Citibank, derivatives, Economics, Employment, finance, short selling

Click Image for Animation

Technorati Tags Economic Indicators, unemployment

Employment as measured by the “establishment survey,” was down by 190,000; and Many feel it is an improvement that we are not falling as fast.

Well, let us take a moment to look under the hood of these numbers. First, while the establishment survey was down 190k, the number of unemployed soared by 558,000, to 15.7 million, as measured by the household survey. The establishment survey is taken from large businesses while the household survey calls individual households. It is the household survey that sets the unemployment rate. The establishment survey of companies doesn’t count the self-employed and undercounts employees of small businesses. So the economic picture is probably worse than the headlines when it comes to jobs.

Let’s look at the establishment survey. The actual change in unemployment for October was 641,000, not 190,000 which is seasonally adjusted. The so-called birth-death ratio added 86,000. Who knows if that is a reasonable statistical adjustment. While we should adjust the number seasonally, in the real world the jobs were still lost.

The total (U-6) employment rate has climbed to a record high of 17.5%. This is complied by adding in those employed part time for economic reasons. Total job losses since the onset of the recession now are approximately 10.5 million.

From John Mauldin we get this report from Greg Weldon (www.weldononline.com). Greg points out one of the issues with just looking at unemployment, because if you have not looked for a job in four weeks they no longer count you as unemployed:

Moreover, when we combine the monthly change in the number of Unemployed, with the number Not in the Labor Force, we might consider the result to be a proxy for the actual ‘change’ in the underlying labor market situation … in which case, October’s figure of 817,000 represents the fourth LARGEST yet, behind last month’s (September’s) second largest figure of 1,021,000 … for a two-month combined figure of 1.838 million, in newly Unemployed, or no longer ‘in’ the Labor Force …

… the second LARGEST two-month total EVER posted, barely trailing the December-08/January-09 total 1.955 million.

Bottom line … basis this measure AND the ‘Total Unemployment Rate,’ we could conclude that not only is there NO ‘improvement’ in the labor market, but moreover, that it continues to DETERIORATE, intently.

Of course, unemployment is typically a lagging indicator, but not always. In a “balance sheet” recession where home price declines, rising defaults (yes they are still rising) credit losses, a wave of foreclosures as large or larger than the subprime tsunami and deleveraging are in motion, unemployment rising at the rate we are seeing now is likely to be a significant drag for years to come.

Looking back at 1982, which so many people told us was far worse than today could ever be, we see households dealing with similar “levels” of unemployment with more than three times the debt load and half the savings. Workers are finding it takes longer to find work than in 1982. The count of people jobless for six months or longer stands at a record 5.6 million.

There was a bright spot, though it is so early we might see it revised down or a statistical aberration. Temporary employment grew by 33,700 jobs, its third straight month of gains after steep losses earlier this year. Typically employers add temporary workers before hiring permanent ones.

The even uglier fact. Average hours worked still stands at 33, a record low. Two important things to be gleaned form that number:

1. The unemployment number is much lower than it otherwise would be because workers hours have been cut rather than jobs lost.
2. Hiring is likely to be slower than normal as early on we will see hours worked rise rather than bring in new employees.

So how are companies beating their estimates amidst all this gloom? First off, they always beat their estimates. They are not beating the estimates of a year ago, or six months ago, or even three months ago. They are beating the estimates which keep getting chopped almost until they are reported. The estimates six months out from now are unlikely to be met, but by then they will be reduced yet again.

Still, profits are better than many expected six months ago, even if they are worse than the analysts estimates from then as well. Why? John Forsyth gives us the skinny:

The genius of American business for doing more with less has been evident in the parade of earnings reports showing profits improving far more than the revenue that produces them. The secret: Productivity soared at a 9.5% annual rate in the third quarter, a stunning increase that was nearly half again as much as economists had projected. Business cut labor costs at a 5.2% annual rate, with total hours falling at a 5% pace. Fewer workers worked fewer hours.

That is a recipe for deflation and slow growth if it doesn’t reverse. Profits can only be improved by cost cutting for so long, and the carnage amongst workers is made even worse.

Charts are courtesy of Barry Ritholtz. Also posted at The View From the Bluff.

Posted via email from Risk and Return’s Posterous

Technorati Tags economy, Employment, investing

Jake at Econompic gives us this chart, which shows that convertible arbitrage has indeed led the way this year:

Unfortunately, he has a fine post, which shows the dark side of this rally and the “carry trade” which has been helping finance it:

if the correlation of assets purchased is near one on the way up, it is sure as hell going to be that high or higher on the way down. And what happens to all these investors that are attempting to leave the same exit door at the same time? Massive re-purchasing of the dollar and massive selling of any risk asset… joy.

Joy indeed.

Cross posted at “The View From the Bluff.”

Technorati Tags Adam Smith, Economics, great economists, quiz, Robert Whaples

Emma James of the Baton Rouge Business Report interviews myself, Mike Patton of Integrity Wealth Management (a pretty good egg from what I know of him) and Professor Kelley Pace of LSU on the subject of Real Estate Investment Trusts (REIT’s.) I think she does a pretty good job on what is in fact a very complex issue at the moment.

On a longer term basis public REITs are reasonably valued, and the very possible collapse in the Commercial Real Estate market will give public REITs with their more flexible capital structures the ability to buy some very attractive property at distressed prices. However, they will likely be under tremendous pressure in the shorter run, and the overall market environment is likely to be unkind as well. Which means we may get a chance to buy them at a much cheaper price down the road, with the opportunity for them to profit from the distressed property market still in front of us. It may seem a bit like dancing on gravestones, but I would welcome it.

Unlike 2006-2008 I am not of a mind to go “short” publicly traded REITs however, as reasonable long term valuations make that potential decline far from a given.

Posted via web from Risk and Return’s Posterous

Folks, don’t fall for it. The stock market may rise or fall in coming months but “money on the sidelines” will not have anything to do with it. Barry resurrects an old John Hussman piece which is one of my favorite dissections of this myth:

I’ve said this before, but it’s important. If Ricky sells his money market shares and buys stocks, then his money market fund has to sell commercial paper to Nicky, whose currency goes to Ricky, who uses it to pay for the stock bought from Mickey. In the end, the currency that Nicky held is now held by Mickey, the commercial paper held by Ricky is now held by Nicky, and the stock held by Mickey is now held by Ricky, and there is exactly as much stock, commercial paper, and currency outstanding as there was before. All that happened is that the owner of each security has changed.

I suggest reading the whole thing, but if ordinary logic doesn’t prove it then maybe actual facts about the behavior of markets will help, also courtesy of Barry:

Notice, when the market was rising so was cash. It didn’t disappear into the stock market and explain the rising market. In fact, during the tech crash it declined along with the market. Before the most recent market crash this argument “cash on the sidelines” was used to argue why the stock market wouldn’t decline. How did that work out?

Amusingly (if somewhat darkly so) Hussman in the piece above wrote in 2006 how the fallacy might mislead us:

There is an important reason for these considerations here. As I’ve noted in recent months, it’s likely that China and Japan will at least stabilize in their willingness to absorb the flood of government liabilities that they’ve been snapping up in recent years. That means that more of these liabilities will be forced into the hands of U.S. investors. As that happens, we’re likely to observe an accumulation of “cash on the sidelines” that might look like a hopeful sign for stocks.

A hopeful sign that left investors holding the bag. Don’t believe it this time or next time.

Technorati Tags investing, investment myths, John Hussman

Look deeper, however, and the government isn’t really quitting its bailouts at all. It is just shifting strategy away from banks and financial services to a new set of quieter bailouts, centered on the housing and real estate markets in general and Fannie Mae and Freddie Mac in particular. In this way, the administration’s actions are meshing with the wishes of House financial services committee Chairman Barney Frank, who said last year, “I want at least two years with President Obama and a solidly Democratic Senate so that we can get the federal government back in the housing business.” Now it is, even to the point that the government is at risk of creating another mortgage bubble. We just have to see if the government can handle it.

The government has to concentrate all of its resources on keeping the housing and real estate markets stable because the government is now the single biggest investor in mortgage-backed securities. It bought more than 80 percent of all the mortgages issued by Fannie and Freddie. What this means is that if homeowners start to fall behind on those mortgages in even bigger numbers than the current 9.24 percent default rate, the government is in deep trouble, starting with the Federal Reserve. The Fed’s own balance sheet—its financial holdings—has ballooned to $2.1 trillion from just $800 billion a year ago. One-third of the Fed’s balance sheet is weighed down with $625 billion of troubled mortgage-backed securities, once floating around the market and now invited to stay in Uncle Sam’s own accounts.

Read the whole thing.

Technorati Tags Barney Frank, Fannie Mae, Federal Reserve, Freddie Mac, housing crisis, Housing Market

From the New York Times: U.S. Job Seekers Exceed Openings by Record Ratio

Hat tip: The Big Picture

Technorati Tags Employment, the economy, unemployment

Inflation from Marketplace on Vimeo.

Technorati Tags banks, deflation, Inflation

However, working that mountain of debt down needs to be done and will be a large drag for years. Hat tip: Clusterstock

Technorati Tags debt, debt crisis, the economy

Here is part I:

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags credit crisis, deflation, Economic Indicators, Economics, housing, Housing Market, Inflation, investing, markets, monetary policy, Risk, subprime

For some of the best and most insightful financial writing around I recommend combing through his archives. I occasionally do. Revisiting past musings of the greats may not be as immediately useful as some things, but longer term it allows a perspective that will serve you well over time. distributed raman amplifier

One view of the Japanese stimulus (or multiple stimuli) is that it (they) failed because it was (they were) too small. Just as the reason that in World War I all British attacks prior to the Battle of the Somme failed was because they were too small.

Technorati Tags Arnold Kling, Economics, Japan, quotes, World War I

Therefore it is no surprise that it is a larger story in Baton Rouge than elsewhere. Anyway, The Baton Rouge Business Report’s (as fine a local business publication as there is in the United States) Olivia Watkins interviewed me on how those of us in the industry viewed the impact and fallout from this. It was a long discussion, but some of my thoughts on how this kind of thing has played out in the past made it into this story.

Technorati Tags Baton Rouge, Baton Rouge Business Report, CDS, fraud, Ponzi Schemes, Recievers, Stanford Group

Click for larger version of charts.

Technorati Tags economy, Employment, New York Times